Chapter 30 Inflation and Disinflation Notes
x inflation Æ rise in the average level of all pries; usually expressed as the annual percentage change in the Consumer Price Index
30.1 Adding Inflation to the Model
Why Wages Change
x three propositions about how changes in money wages were influenced by the output gap:
1. the excess demand for labour that is associated with an inflationary gap (Y > Y*) puts upward pressure on money wages
2. the excess supply for labour associated with a recessionary gap (Y < Y*) puts downward pressure on money wages
3. the absence of either an inflationary or a recessionary gap (Y = Y*) means that demand forces do not exert any pressure
x when real GDP is equal to Y*, the unemployment rate is said to be equal to the NAIRU, which stands for the non-accelerating
inflation rate of unemployment, sometimes known as the natural rate of unemployment, designated by U*
x the expectation of some specific inflation rate creates pressure for money wages to rise by that rate
x changes in money wages = output-gap effect + expectational effect
x rational expectations Æ the theory that people understand how the economy works and learns quickly from their mistakes so that
even through random errors may be made, systematic and persistent errors are not
From Wages to Prices
x net effect of the two forces action on wages—output gaps and inflation expectations—determines what happens to the AS curve
x actual inflation = output-gap inflation + expected inflation + supply-shock inflation
x if inflation and monetary policy have been constant for several years, expected rate of inflation will equal actual rate of inflation
x in the absence of supply shocks, if expected inflation equals actual inflation, real GDP must be equal to potential GDP
x constant inflation with Y = Y* occurs when the rate of monetary growth, the rate of wage increase, and the expected rate of
inflation are all consistent with the actual inflation rate
30.2 Shocks and Policy Responses
x demand inflation Æ inflation arising from an inflationary output gap caused, in turn, by a positive AD shock
x continued validation of demand shock turns transitory inflation into sustained inflation fuelled by monetary expansion
x supply inflation Æ inflation arising from negative AS shock that is not result of excess demand in domestic markets for FP
x whenever wages and other factor prices fall only slowly in the face of excess supply, the recovery to potential output after a non-
validated negative supply shock will take a long time
x monetary validation of a negative supply shock causes the initial rise in the price level to be followed by a further rise, resulting
in a higher price level than would occur if the recessionary gap were relied on to reduce factor prices
x to some economists, caution dictates that negative supply shocks should never be validated, to avoid wage-price spiral; others are
willing to risk validation in order to avoid significant, though transitory, recessions that otherwise accompany supply shock
x acceleration hypothesis Æ the hypothesis that when real GDP is held above potential, the persistent inflationary output gap will
cause inflation to increase
x according to the acceleration hypothesis, as long as an inflationary output gap persists, expectations of inflation will be rising,
which will lead to increases in the actual rate of inflation
Inflation as a Monetary Phenomenon
x there are three causes of inflation:
1. Cause 1: On the demand side, anything that shifts the AD curve to right will cause price level to rise (demand inflation).
2. Cause 2: On the supply side, anything that shifts the AS curve upward will cause the price level to rise (supply inflation).
3. Cause 3: Unless continual monetary validation occurs, the increases in the price level must eventually come to a halt.
x expectations-augmented Phillips curve Æ the relationship between unemployment and the rate of increase of money wages that
arise when the output-gap and expectations components of inflation are combined
x there are three consequences of inflation, assuming that real GDP was initially at its potential level:
1. Consequence 1: In short run, demand inflation tends to be accompanied by increase in real GDP above its potential level.
2. Consequence 2: In short run, supply inflation tends to be accompanied by decrease in real GDP below its potential level.
3. Consequence 3: When all costs and prices are adjusted fully (so that real GDP has returned to Y*), shifts in either the AD
or AS curve leave real GDP unchanged and affect only the price level.
x this leads to three important conclusions:
1. Conclusion 1: Without monetary validation, positive demand shocks cause inflationary output gaps and a temporary burst
of inflation. The gaps are removed as rising factor prices push the AS curve upward, returning real GDP to its potential
level, but at a higher price level.
2. Conclusion 2: Without monetary validation (MV), negative supply shocks cause recessionary output gaps and a
temporary burst of inflation. The gaps are eventually removed as factor prices fall, restoring real GDP to its potential and
the price level to its initial level.
3. Conclusion 3: Only with continuing MV can inflation initiated by either supply or demand shocks continue indefinitely.
x sustained inflation is everywhere and always a monetary phenomenon